Microeconomics

By Arnold C. Harberger

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Until the so-called Keynesian revolution of the late 1930s and 1940s, the two main parts of economic theory were typically labeled “monetary theory” and “price theory.” Today, the corresponding dichotomy is between “macroeconomics” and “microeconomics.” The motivating force for the change came from the macro side, with modern macroeconomics being far more explicit than old-fashioned monetary theory about fluctuations in income and employment (as well as the price level). In contrast, no revolution separates today’s microeconomics from old-fashioned price theory; one evolved from the other naturally and without significant controversy.

The strength of microeconomics comes from the simplicity of its underlying structure and its close touch with the real world. In a nutshell, microeconomics has to do with supply and demand, and with the way they interact in various markets. Microeconomic analysis moves easily and painlessly from one topic to another and lies at the center of most of the recognized subfields of economics. Labor economics, for example, is built largely on the analysis of the supply and demand for labor of different types. The field of industrial organization deals with the different mechanisms (monopoly, cartels, different types of competitive behavior) by which goods and services are sold. International economics worries about the demand and supply of individual traded commodities, as well as of a country’s exports and imports taken as a whole, and the consequent demand for and supply of foreign exchange. Agricultural economics deals with the demand and supply of agricultural products and of farmland, farm labor, and the other factors of production involved in agriculture.

Public finance (see public choice) looks at how the government enters the scene. Traditionally, its focus was on taxes, which automatically introduce “wedges” (differences between the price the buyer pays and the price the seller receives) and cause inefficiency. More recently, public finance has reached into the expenditure side as well, attempting to analyze (and sometimes actually to measure) the costs and benefits of various government outlays and programs.

Applied welfare economics is the fruition of microeconomics. It deals with the costs and benefits of just about anything—government projects, taxes on commodities, taxes on factors of production (corporation income taxes, payroll taxes), agricultural programs (like price supports and acreage controls), tariffs on imports, foreign exchange controls, various forms of industrial organization (like monopoly and oligopoly), and various aspects of labor market behavior (like minimum wages, the monopoly power of labor unions, and so on).

It is hard to imagine a basic course in microeconomics failing to include numerous cases and examples drawn from all of the fields listed above. This is because microeconomics is so basic. It represents the trunk of the tree from which all the listed subfields have branched.

At the root of everything is supply and demand. It is not at all farfetched to think of these as basically human characteristics. If human beings are not going to be totally self-sufficient, they will end up producing certain things that they trade in order to fulfill their demands for other things. The specialization of production and the institutions of trade, commerce, and markets long antedated the science of economics. Indeed, one can fairly say that from the very outset the science of economics entailed the study of the market forms that arose quite naturally (and without any help from economists) out of human behavior. People specialize in what they think they can do best—or more existentially, in what heredity, environment, fate, and their own volition have brought them to do. They trade their services and/or the products of their specialization for those produced by others. Markets evolve to organize this sort of trading, and money evolves to act as a generalized unit of account and to make barter unnecessary.

In this market process, people try to get the most from what they have to sell, and to satisfy their desires as much as possible. In microeconomics this is translated into the notion of people maximizing their personal “utility,” or welfare. This process helps them to decide what they will supply and what they will demand.

When hybrid corn first appeared in the United States, it was in experiment stations, not on ordinary farms. But over a period of decades it became the product of choice of hundreds of thousands of farmers. At the beginning of the process, those who adopted the new hybrids made handsome profits. By the time the transition was complete, any farmer who clung stubbornly to the old nonhybrid seed was likely to be driven out of business, leaving only farmers who acted as if they were profit maximizing; the ones who did not had failed. By a very similar process new varieties of wheat spread through the Punjab and other parts of India in the 1960s, and new varieties of rice through the Philippines and the rest of East Asia. What economists call “maximizing behavior” explains the real-world behavior of these millions of farmers, whose actions increased the supply of corn, wheat, and rice, making much more of these products available to the consumers of the world at lower prices.

Similar scenarios reveal how maximizing behavior works on the demand side. Today’s textiles include vast amounts of artificial fibers, nearly all of them unknown a century ago. They conquered markets for themselves, at the expense of the older natural fibers, because consumers perceived them to be either better or cheaper, or both. In the end, when old products end up on the ash heap of history, it is usually because consumers have found new products that they greatly prefer to the old ones.

The economics of supply and demand has a sort of moral or normative overtone, at least when it comes to dealing with a wide range of market distortions. In an undistorted market, buyers pay the market price up to the point where they judge further units not to be worth that price, while competitive sellers supply added units as long as they can make money on each increment. At the point where supply just equals demand in an undistorted market, the price measures both the worth of the product to buyers and the worth of the product to sellers.

That is not so when an artificial distortion intervenes. With a 50 percent tax based on selling price, an item that costs $1.50 to the buyer is worth only $1.00 to the seller. The tax creates a wedge, mentioned earlier, between the value to the buyer and the return to the seller. The anomaly thus created could be eliminated if the distortion were removed; then the market would find its equilibrium at some price in between (say, $1.20) where the product’s worth would be the same to buyers and to sellers. Whenever we start with a distortion, we can usually assert that society as a whole can benefit from its removal. This is epitomized by the fact that buyers gain as they get extra units at less than $1.50, while sellers gain as they get to sell extra units at more than $1.00.

Many different distortions can create similar anomalies. If cotton is subsidized, the price farmers get will exceed, by the amount of the subsidy, the value to consumers. Society thus stands to gain by eliminating the subsidy and moving to a price that is the same for both buyers and sellers. If price controls keep bread (or anything else) artificially cheap, the predictable result is that less will be supplied than is demanded. Nine times out of ten, the excess demand will end up being reflected in a gray or black market, whose existence is probably the clearest evidence that the official price is artificially low. In turn, economists are nearly always right when they predict that pushing prices down via price controls will end up reducing the amount supplied and generating black-market prices not only well above the official price, but also above the market price that would prevail in the absence of controls.

Official prices that are too high also produce curious results. In the 1930s the U.S. government adopted socalled parity prices for the major grains and a few other farm products. Basically, if the market price was below the parity price, the government would pay farmers the difference or buy any unsold crops at the parity price. The predictable result was production in excess of the amount demanded—leading to surpluses that were bought up (and stored) by the government. Then, in an effort to eliminate the purchase of surpluses (but without reducing the parity price), the government instituted acreage controls under which it paid farmers to take land out of production. Some people were surprised to see that a 20 percent cut in wheat acreage did not lead to a 20 percent fall in the production of wheat. The reason was that other factors of production could be (and were) used more intensively, with the result that in order to get a 20 percent cut in wheat, acreage “had to” be cut by 30–40 percent.

Economists have a better solution. Had the government given wheat farmers coupons, each of which permitted the farmer to market one bushel of wheat, wheat marketings could have been cut by the desired amount. Production inefficiencies could be avoided by allowing the farmers to buy and sell coupons among themselves. Low-cost farmers would buy coupons from high-cost farmers, thus ensuring efficient production. This is known as a “second-best” solution to a policy problem. It is second rather than first best because consumers would still be paying the artificially high parity price for wheat.

monopoly represents the artificial restriction of production by an entity having sufficient “market power” to do so. The economics of monopoly are most easily seen by thinking of a “monopoly markup” as a privately imposed, privately collected tax. This was, in fact, a reality a few centuries ago when feudal rulers sometimes endowed their favorites with monopoly rights over certain products. The recipients need not ever “produce” such products themselves. They could contract with other firms to produce the good at low prices and then charge consumers what the traffic would bear (so as to maximize monopoly profit). The difference between these two prices is the “monopoly markup,” which functions like a tax. In this example it is clear that the true beneficiary of monopoly power is the one who exercises it; both producers and consumers end up losing.

Modern monopolies are a bit less transparent, for two reasons. First, even though governments still grant monopolies, they usually grant them to the producers. Second, some monopolies just happen without government creating them, although these are usually short-lived. Either way, the proceeds of the monopoly markup (or tax) are commingled with the return to capital of the monopoly firms. Similarly, labor monopoly is usually exercised by unions, which are able to charge a monopoly markup (or tax), which then becomes commingled with the wages of their members. The true effect of labor monopoly on the competitive wage is seen by looking at the nonunion segment of the economy. Here, wages end up lower because the union wage causes fewer workers to be hired in the unionized firms, leaving a larger labor supply (and a consequent lower wage) in the nonunion segment.

A final example of what occurs with official prices that are too high is the phenomenon of “rent seeking,” which occurs when someone enters a business to earn a profit that the government has tried to make unusually high. A simple example is a city that imposes a high official meter rate for taxis but allows free entry into the taxi business. The fare must cover the cost of paying a driver plus a market rate of return on the capital costs involved. Labor and capital will flow into the cab industry until each ends up getting its expected, normal return instead of the high returns one would expect with high fares. What will adjust is simply the number of cabs and the fraction of the time they actually carry passengers. Cabs will get more for each rider, but each cab will have fewer riders.

Other situations of rent seeking occur when artificially high urban wages attract migrants from rural areas. If the wage does not adjust downward to equate supply and demand, the rate of urban unemployment will rise until further migration is deterred. Still other examples are in banking and drugs. When the “margin” in banking is set too high, new banks enter and/or branches of old ones proliferate until further entry is deterred. Artificially maintained drug prices led, in several Latin American countries (Argentina, Chile, and Uruguay before their major liberalizations of recent decades), to a pharmacy on almost every block.

Rent seeking also occurs when something of value (like import licenses or radio/TV franchises) is being given away or sold below its true value. In such cases potential buyers often spend large amounts “lobbying” to improve their chances of getting the prize. Indeed, a broad view of rent seeking easily covers most cases of lobbying (using real resources in efforts to gain legislative or executive “favors”).

The great unifying principles of microeconomics are, ever and always, supply and demand. The normative overtone of microeconomics comes from the fact that competitive supply price represents value as seen by suppliers, and competitive demand price represents value as seen by demanders. The motivating force is that of human beings, always gravitating toward choices and arrangements that reflect their tastes. The miracle of it all is that on the basis of such simple and straightforward underpinnings, a rich tapestry of analysis, insights, and understanding can be woven. This brief article can only give its readers a glimpse—hopefully a tempting one—of the richness, beauty, and promise of that tapestry.

About the Author

Arnold C. Harberger is a professor of economics at the University of California in Los Angeles. He is also the Gustavus F. and Ann M. Swift Distinguished Service Professor Emeritus at the University of Chicago. He has consulted extensively on microeconomic issues for many international organizations, including the International Monetary Fund, the World Bank, and the Inter-American Development Bank; governments, including Argentina, Bolivia, Brazil, Canada, Chile, India, and Mexico; and corporations, including Bechtel International, Republic Steel, and Ontario Hydro. He was special ambassador, U.S. Department of State, in 1984 and was on a presidential mission to Poland in 1989. He was president of the Western Economic Association from 1989 to 1990, and president of the American Economic Association in 1997.

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